Lower growth plus higher inflation may lead to lower fund inflows

Three sets of economic data—the HSBC Manufacturing Purchasing Managers’ Index (PMI) for July, the Prime Minster’s economic advisory council’s (EAC) forecast for 2011-12 and the June foreign trade figures—all vindicate the Reserve Bank of India’s (RBI) stand in raising its policy rate by 50 basis points. One basis point is one-hundredth of a percentage point.

The manufacturing PMI number, however, is indicating a rather sharp deceleration. The index has declined from 58 in April to 53.6 in July. It was at 55.3 in June. The new orders sub-index, which is an indicator of future output, has eased from 63.9 in April to 54.5 in July. The trouble is that in spite of the moderation in growth, the PMI numbers show that both input and output prices in the manufacturing sector rose in July.

The sub-index for input prices is still at a very high 64.3 (the PMI indices and sub-indices signify expansion from the previous month if they are above 50) and that for output prices increased to 56 in July from 54.6 in June, indicating firms are passing on the increase in input prices, which means demand continues to be strong.

EAC is also counting on consumer demand to remain resilient this fiscal and it expects growth in private consumption expenditure to be 7.6%. That will support the gross domestic product growth at 8.2%, which, although lower than its earlier estimate of 9% made in February this year, is still quite strong.

Investment demand, in contrast, has fallen sharply and growth in private gross domestic capital formation fell from 29.1% in 2009-10 to 6.6% in 2010-11. EAC had been far more upbeat during its earlier assessment in February, when it pegged private gross capital formation growth at 15.3% in 2010-11 and 15.9% in 2011-12. It now realizes those numbers were gross over-estimations. The council expects private investment demand to pick up to 7.9% in 2011-12. But why that should happen despite higher interest rates is unclear.

Incidentally, EAC’s forecast gives a large role to government. It had previously estimated government final consumption expenditure to grow by 2.6% in 2010-11 and 3% in 2011-12. It now says government consumption increased by 4.8% in 2010-11 and is forecast to increase by 5% in 2011-12. No wonder the forecast raises questions about the government’s ability to meet fiscal deficit targets.

The commerce ministry’s June export numbers also show robust growth. Growth is strong in imports, too, including non-oil imports, which are often taken as a proxy for domestic demand conditions. Nevertheless, the PMI sub-index for export orders shows a contraction in July—it dropped below 50 to 49.2. That’s an indication of a slowdown in external demand in future.

On inflation, EAC echoes RBI’s prognosis, although it pegs wholesale price inflation at 6.5% by end-March 2012, while the central bank says it’ll be 7%. Most likely, given the track record of their forecasts, inflation is likely to be higher.

If growth is slowing and inflation remains stubbornly high, could there be a silver lining through higher global liquidity, which will ensure fund flows to the Indian markets?

EAC doesn’t think so. It has said that portfolio inflows in 2011-12 will be around $14 billion (Rs61,600 crore today), less than half of 2010-11’s $30.3 billion. A substantial chunk of that will go into the debt markets, leaving precious little for equities.